Big Ben, This is Rubber Duck - Episode 14
posted on Tuesday, January 19, 2021 in General
Hello and thank you for joining us for another episode of The Insider, a bi-weekly podcast production of the Federal Home Loan Bank of Des Moines and your source for industry news, strategies and key information about the bank. This is your host, John Biestman, Senior Relationship Manager.
In this New Year, my mind drifted off to the simpler eight-track times in 1975 when I would drive from home to college to the tune of the number-one hit on the pop and country chart, a song called “Convoy.” The song celebrated the CB radio, or citizens band phenomenon that was, no doubt, a pre-cursor of today’s prolific communication culture. Not only was there a CB culture, but there was a CB language.
In addition to the familial “10-4,” there were less remembered phrases: Facilities such as chicken coops (or truck scales). Vehicles such as Buster Browns (or UPS trucks). Or, even obstacles such as “alligators,” or a large piece of tire on the road, from a distance they can resemble an alligator sunning on the road. Those days, every CB radio user held a nickname, or handle, as was the case in the “Convoy” song’s reference to “Big Ben” and “Rubber Deck.”
Speaking of handles, the yield on the benchmark 10-year US Treasury note now sports a “one-handle.” That is, yield handles are now above 1.00% for the first time since March of 2020. Reasons seem to be plenty: the possibility of greater-than-expected fiscal stimulus in the wake of the Georgia runoff election, hopes that once safe and effective vaccines become prolific, that pent-up consumer and commercial demand will emerge alongside a seemingly limitless supplies of treasury debt.
As we now enter the world of the 1% handle, it may be time to recalibrate inflationary expectations. During 2020, inflation was relative tame, with the CPI and PCE lying in the 1.5% range. Still, with money supply having increased by 25% since March of 2020, it’s no surprise that, for instance, an RBC investment survey found that 59% of respondents were forecasting a pick-up in inflation during the New Year, though hopefully not to the degree of 1975 when I remember wearing a button inscribed “Whip Inflation Now.”
While the non-stimulative effects of a high savings rate, low labor participation and commercial rent prospects could hold back inflationary prospects; the sheer amount of liquidity, low interest rates, vaccine administration and pent-up demand could cause many institutions to evaluate the potential of the yield curve to further steepen.
Speaking of low labor participation, the December employment situation report showed that four million Americans have simply ceased looking for work since the onset of the pandemic. Moreover, the report highlighted a loss of 140,000 jobs during December, way below expectations and the first decline in employment since April of last year.
So, as we will soon gain more knowledge about how the industry fared in the final quarter of 2020, Recent Fed H-8 reports are showing that the pace of Q4 loan shrinkage, particularly due to C&I loans and line pay-downs, a little over 1% quarter-over-quarter, is similar to what occurred in the third quarter.
With securities portfolios now bursting at the seams, it should be no surprise that margin compression will persist. Not surprisingly, bank deposits increased quarter-over-quarter by roughly 3%.
So, to sum up the sheer amount of further prospective excess liquidity, it’s not just another round of PPP or ongoing fiscal stimulus; it’s also about accelerating payoffs of commercial loans, prepaying mortgages that are being reported throughout the membership. Referring back to the rudimentary definition of inflation, “too much money chasing too few goods and services,” the forward markets that reflect this possibility are starting to make a statement.
For instance, the difference between TIPS or treasury inflation-protected bonds and their counterpart Treasury yields, are at their widest spreads since October of 2018. This spread is an interesting gauge to follow. The index, now above 2%, currently assumes that the 10-year treasury with a yield of 1.10% versus a negative 1.00% yield on 10-year inflation-protected treasuries.
This spread, known as the “break-even” inflation rate implies that if actual inflation is higher than the break-even rate, in this case, 2.08%; an investor would be better off owning these inflation-adjusted treasuries than they would be in the case of standard 10-year Treasuries. So, again, watch the “break-even” inflation rate. It’s regularly published by the St. Louis Federal Reserve Bank.
Here we are with money supply having grown at an annual rate of 25%. Of late, the Fed has been buying on the order of $120 billion in securities monthly. When this amount of money is being printed, it needs to go somewhere besides into deposits. At least through the traditional metrics, there is very limited inflation, at least at the consumer level. We may need to consider this assumption with a modicum of caution.
If we consider where the printed money is going, there’s some evidence that it’s going to rising asset prices. Consider rising equity prices, let alone home prices. In fact, the Case Schiller Home Price Index now stands at 25% higher than it was at the previous cyclical peak just before the Great Recession in 2007. So much for a vibrant first-time homebuyer market and all the more reason to talk to your Relationship Manager about the new 2021 HomeStart program updates. The $7 million program will be distributed in quarterly increments this year.
Let’s think about the impact of a so-called “bear-steepener.” We know that the Fed would not overly object to at least a temporary level of inflation above 2.00%. While many financial institutions are known to benefit from a steeper curve, as most are asset-sensitive, meaning that their assets are re-pricing more frequently than their funding; there’s good reason to believe that many institutions are not as asset-sensitive as they were a year ago.
Why? First, deposit durations have changed. As rates have descended toward zero, some deposits may have become transitory. Think PPP-related deposits or deposits that may simply go to the highest bidder. All the while you should be pushing your funding costs as low as they can go. Second, consider your asset duration trends. On the demand side, your borrowers are increasingly looking to lock in loans at current rates with longer durations. The same might hold true for institutions that are looking for investment yields that may look all the more attractive as the yield curve steepens.
It’s not a bad idea to take good stock of your institution’s balance sheet sensitivity as we start the New Year. For instance, if you are thinking about prospects for a bear steepener, how might you position your balance sheet if you are less asset-sensitive than you once were?
You could always increase your lost asset-sensitivity by several measures. You could, for instance, shorten your investment and loan durations. On the liability side, you could find ways to lengthen you funding durations, either through term advances or initiating a program of rolling shorter-term advances in combination with fixed rate interest rate swaps.
Another question to ask yourself: Should you diversify and re-balance your liability structure with a bit more duration-certain advance funding to address the higher duration uncertainty of your deposits? If, or better yet, when rates rise, you’ll likely want to position yourself with assets that are reliably re-pricing at a faster rate than your liabilities. The yield curve has steepened. Measure and monitor any further impact on your net interest margins and market value of equity.
It’s easy to remember one of the observations made during our inaugural FHLB Des Moines Insider podcast on the “Paradox of Thrift” back in May of 2020 in which we highlighted that the personal savings rate reached 35% of disposable income during the spring of 2020, thanks to the large infusion for federal stimulus payments. At least at that time, for every dollar of stimulus money, only one-third was saved. The remainder was directed to debt reduction and savings. In recent history, at least, fiscal stimulus has been as much a story of deleveraging, and increasing savings as it has been about incremental spending.
A lot of us have been trying to figure out the disconnection between the somewhat dystopian economic headlines versus the significant reported declines in loan deferrals and minimal deterioration in performing credits.
Perhaps it’s the healing effects of PPP and other programs, but loan deferrals as of the end of Q3 2020 stood at 4% of loans exclusive of PPP loans, down from the nearly 10% level that was recorded at the end of Q2.
Paradoxically, the credit outlook has improved even though there are few signs of economic recovery. It’s fair to assume that at least the visible signs of credit deterioration may continue as they are as long as economic relief packages such as PPP2 and large-scale fiscal stimulus programs perpetuate.
True reported credit condition may become further opaque in that the CARES Act extended a key expiration extension to January, 2022, that being no requirement to classify loan deferrals as TDR’s or troubled debt restructurings until then. It’s probably fair to assume that the longer a loan remains on deferral, the higher the probability that such a loan would ultimately be classified as non-performing.
We’ll see you next time on the FHLB Des Moines Insider Podcast.
Stay well, safe, liquid and with a steady grip on the wheel! Whether the road takes you to a bear steepener, a bull flattener, a bear flattener or a bull steepener, we’re here to help you stay in your lane and manage your interest rate risk. Thanks for tuning in. “10-4.”
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